Setting Profit Traps with Butterfly Spreads

By: Staff at Investopedia.com

This strategy is best used when a trader expects the underlying stock to move somewhat higher, but does not have a specific forecast regarding the magnitude of the move,writes the staff at Investopedia.com.

Individuals trade options for a variety of reasons. Some people trade them in order to speculate on the expectation of a given price moment, while others use options to hedge an existing position. Others use more advanced strategies in hopes of generating extra income on a regular basis. All of these are valid objectives and can be successful if done correctly. Still, there is a whole range of unique strategies along the option trading strategy spectrum that offer outstanding reward-to-risk potential for those willing to consider the possibilities. One such strategy is the out-of-the-money butterfly spread (heretofore referred to as the OTM butterfly).

Definition of a Butterfly Spread
Before delving into the OTM butterfly, let’s first define what a basic butterfly spread is; a butterfly spread represents a strategy completely unique to option trading. The most basic form of a butterfly spread involves buying one call option at a particular strike price while simultaneously selling two call options at a higher strike price and buying one other call option at an even higher strike price. When using put options, the process is to buy one put option at a particular strike price while simultaneously selling two put options at a lower strike price and buying one put option at an even lower strike price.

The net effect of this action is to create a "profit range," a range of prices within which the trade will experience a profit over time. A butterfly spread is most typically used as a "neutral" strategy. In Figure 1 you see the risk curves for a neutral at-the-money butterfly spread using options on First Solar (FSLR).

Figure 1 - FSLR 110-130-150 Call Butterfly
Click to Enlarge

The trade displayed in Figure 1 involves buying one 110 call, selling two 130 calls, and buying one 150 call. As you can see, this trade has limited risk on both the upside and the downside. The risk is limited to the net amount paid to enter the trade (in this example: $580).

The trade also has limited profit potential, with a maximum profit of $1,420. This would only occur if FSLR closed exactly at $130 on the day of option expiration. While this is unlikely, the more important point is that this trade will show some profit as long as FSLR remains between roughly 115 and 145 through the time of option expiration.

Definition of an OTM Butterfly Spread
The trade displayed in Figure 1 is known as a "neutral" butterfly spread, because the price of the option sold is at the money. In other words, the option sold is close to the current price of the underlying stock. So, as long as the stock does not move too far in either direction, the trade can show a profit. An OTM butterfly is built the same way as a neutral butterfly, by buying one call, selling two calls at a higher strike price and buying one more call option at a higher strike price.

The critical difference is that with the OTM butterfly, the option that is sold is not the at-the-money option but rather an out-of-the-money option. To put it another way, an OTM butterfly is a "directional" trade. This simply means that the underlying stock must move in the anticipated direction in order for the trade to ultimately show a profit. If an OTM butterfly is entered using an out-of-the-money call, then the underlying stock must move higher in order for the trade to show a profit. Conversely, if an OTM butterfly is entered using an out-of-the-money put option then the underlying stock must move lower in order for the trade to show a profit.